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Decisive Interpretation of Bank Guarantees and Letters of Comfort in Transfer Pricing Cases by Income Tax Appellate Tribunal

Introduction

The recent decision by the Income Tax Appellate Tribunal (‘ITAT’), Ahmedabad in the case of Axis Bank Ltd. v. Assistant Commissioner of Income -Tax[i],  addressed multiple issues arising from an assessment order dated 28.07.2022, passed by the assessing officer (‘AO’) under ss. 143(3), 144C(13), and 144B of the Income Tax Act, 1961 (‘Act’). The case revolved around six key grounds of challenge against the assessment order. These included the disallowance of annual technical service fees (‘ATS’) and expenses related to exempt income under s. 14A of the Act, addition of commission income, interest income on non-performing assets (‘NPAs’), deduction claimed for expenses related to the Employees Stock Option Plan (‘ESOP’), and transfer pricing (‘TP’) adjustment on interest charged on a Tier-II loan to an associate enterprise.

ITAT ruling was comprehensive. It directed the deletion of the disallowance of ATS fees, citing precedents of consistent allowance by higher authorities in previous years. Similarly, the invocation of r. 8D of the IT Rules, 1962 (‘Rules’) for computing disallowance under s. 14A of the Act was deemed erroneous, leading to its deletion. Additionally, ITAT ordered the deletion of the addition of commission income and interest on NPAs, citing consistent precedents and a lack of new adverse judicial decisions. However, the issue of ESOP expenses was sent back to the assessing officer for fresh adjudication due to inconsistencies and ongoing legal developments. In the matter of transfer pricing adjustment, while rejecting the equating of a letter of comfort (‘LOC’) with bank guarantees, the ITAT accepted the adjustment based on safe harbour rules, directing the AO accordingly.

Ultimately, ITAT partially allowed the appeal, emphasizing legal consistency and adherence to prevailing law, thus providing clarity on various contentious tax issues.

Facts

  • The assessee contested the order of the AO for the A.Y. 2018-19 under ss. 143(3), 144C(13), and 144B of the Act on six key grounds.

  • Ground No. 1: This concerned the disallowance of the claim of ATS fees amounting to Rs.48,66,726, deemed as prior period expenses by the AO.  The ATS fees were for the maintenance of the core banking software ‘Finacle’ by Infosys Technologies Limited, charged per user to resolve operational difficulties faced by the bank.

  • The dispute resolution panel (‘DRP’) had directed the disallowance to be made merely to keep the issue alive, despite consistent allowance of similar expenses in preceding years by the CIT(A) and ITAT.

  • Ground No. 2: This revolved around the disallowance of expenses related to exempt income under Section 14A of the Act, despite the assessee’s Suo-moto disallowance of Rs.1,03,08,336 and explanation of its calculation methodology.

  • Ground No. 3: This concerned the addition of commission income amounting to Rs.188,32,58,331 disputed by the assessee due to a change in the method of recognizing commission income over the period of guarantee. Despite the consistent deletion of similar additions by the ITAT in preceding years, the DRP directed the AO to make the addition, citing ongoing departmental appeals.

  • Ground No. 4: This involved the addition of interest income on NPAs totalling Rs. 237.98 crores, based on divergent treatment of overdue periods by the Income-tax Rules and RBI guidelines.

  • Ground No. 5: This involved the deduction claimed by the assessee under s. 37(1) of the Act for expenses related to the ESOP, amounting to Rs.155,60,31,183. The deduction was based on the difference between the market price and the exercise price of shares issued to employees under the ESOP scheme.

  • Ground No. 6: This is related to the transfer pricing adjustment on interest charged on a Tier-II loan to an associate enterprise, contested by the appellant regarding the treatment of LOC and upfront fees.

  • The assessee aggrieved from the assessment order appealed to the ITAT regarding the said issues on the aforementioned grounds.


Held

  • The ITAT partly allowed the appeal filed by the assessee for statistical purposes while giving a finding on each of the aforementioned grounds.

  • The ITAT directed the deletion of the disallowance of ATS fees, considering the consistent allowance of similar expenses in preceding years by higher authorities.

  • Regarding ground No. 2, the ITAT found the AO’s invocation of r. 8D of the Rules, for computing the disallowance under Section 14A to be erroneous. It emphasized that the AO must first indicate dissatisfaction with the assessee’s claim before invoking r. 8D, as per the decision of the jurisdictional High Court in CIMS Hospital P. Ltd. case.[ii]

  • ITAT further held that the assessee had provided a scientific basis for the computation of disallowance, which the AO failed to address adequately, making only general and factually incorrect comments. Therefore, ITAT ruled that the AO’s reliance on r. 8D without fulfilling the prerequisite of dissatisfaction with the assessee’s computation was against the law and hence the disallowance of expenses amounting to Rs.43.59 crores under s. 14A of the Act, made in accordance with r. 8D was deemed unsustainable and directed to be deleted.

  • On the issue raised in the ground no. 3 and 4, ITAT directed the deletion of the addition of commission income and interest on NPAs, citing consistent deletions by the ITAT in preceding years and a lack of new adverse judicial decisions.

  • On the issue of ESOP expenses raised in ground no. 5 of the appeal, considering the admission by the assessee’s counsel regarding the restoration of similar expenses in preceding years for fresh adjudication, ITAT decided to restore the impugned issue to the AO. Thus, ground No. 5 was allowed for statistical purposes, indicating that the matter would be re-examined by the AO in accordance with the current legal framework.

  • Lastly, on the issue regarding transfer pricing adjustment raised in ground no. 6, the ITAT rejected the equating of LOC with bank guarantees, yet accepted the adjustment based on safe harbour rules, directing the AO accordingly.


Analysis

The ITAT’s ruling in Axis Bank Ltd. v. Assistant Commissioner of Income-Tax (supra) offers clarity on multiple tax issues. Notably, the ITAT directed the deletion of disallowed ATS fees and expenses under s. 14A of the Act due to procedural errors by the AO emphasized consistency in prior rulings for commission income and NPAs, restored the issue of ESOP expenses for fresh adjudication, and rejected the equating of LOCs with bank guarantees while accepting adjustments based on safe harbour rules for transfer pricing. The ITAT’s acceptance of interest rates under the ‘safe harbour rules’ as the arm’s length price demonstrates a practical approach to resolving disputes in complex financial transactions.

Overall, the ITAT’s ruling provides clarity on various contentious tax issues, emphasizing the importance of procedural fairness, adherence to legal principles, and consistency in tax assessments, providing valuable guidance for taxpayers and tax authorities alike.





End Notes

[i] IT Appeal No.365 of 2022

[ii] PCIT Vs. CIMS Hospital (P.) Ltd., MANU/GJ/1720/2020




Authored by Pratima Ajmera, Advocate at Metalegal Advocates. The views expressed are personal and do not constitute legal opinion.

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